The Big Idea
Dominican Republic | Reform agenda
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The recent withdrawal of tax reform deals in the Dominican Republic is a heavy blow to credit rating expectations. Not only is the investment grade rating in question, but so too is the one-notch upgrade to ‘Ba2/BB’ from Moody’s and Fitch. Revenues from tax reform are critical for reducing the ratio of interest to revenue and providing a buffer against fiscal shock. The Abinader administration instead is leaning on the Fiscal Responsibility Law to for fiscal consolidation. On lessons learned from Costa Rica, this is not ideal, especially in countries with weaker rule of law.
Dominican Republic for weeks has traded tight to peers like Costa Rica and Guatemala, especially on the long end of the curve. Skepticism about the tight spread was reinforced by underwhelming tax reform that left no buffer for any revisions and no obvious strategy to reduce the 3%-of-GDP structural fiscal deficit. These tight relative valuations quickly unwound after the announcement; however, this setback merits a broader reassessment of relative value and maybe an unwind of all the reform momentum gains since last July. The Dominican Republic should trade with a liquidity penalty to Costar/Guatemala on the long end of the curve, especially if not an upgrade candidate
The tax reform was always the critical component of the broader reform agenda. These revenues represent an important boost to what are mostly rigid budgets across Central America and the Caribbean. These revenues alone would represent a one notch upgrade to ‘Ba2/BB’ irrespective whether it was enough to reduce the fiscal deficit. Now that upgrade is in question. The withdrawal was resolute and a worst-case scenario to other alternatives of negotiated revisions within the legislature or internal revisions within the presidential committee. The politics now dominate. There isn’t the apparent commitment of the Abinader administration to spend their political capital against the complacency of a high growth economy. There were no steps to find consensus and instead confirmation of no reform. This now merits a broader assessment on the potential credit ratings and relative valuation.
What is the reform agenda for the country? The approval of the fiscal responsibility law is an important signal of spending restraint. However, there have been mixed messages and (yet) no track record. The fiscal consolidation through spending restraint alone is a high-risk strategy and will merit a track record of progress. Costa Rica is unique for its law-based culture and a successful multi-year track record of spending restraint. There have been maybe mixed signals from the Dominican Republic with proposals for less spending on greater budgetary efficiency as well as counterproposals for higher spending sourced from the proposed tax revenues. There has yet been a commitment for net fiscal consolidation with a proposed trend budget deficit of 3%-of-GDP in 2025.
The fiscal responsibility law alone may not prove sufficient for deficit reduction on any shock for lower revenues. The International Monetary Fund Article IV review makes ambitious assumptions on the gradual reduction of controversial electricity subsidies while the restricted budget will still have to finance the re-capitalization of the central bank. The underlying trends on the budget this year are quite worrisome on above-trend spending financed with one-off revenues (spending at 16% exceeding 9% year-over-year tax revenues through August). The fiscal deficit could actually worsen under the fiscal rule if there aren’t sufficient or extraordinary revenues next year.
The confirmation of no tax reform should postpone the one notch upgrade to flat ‘BB’ and imply an uncertain trajectory towards an investment grade rating. The weaker ‘BB-‘ rating now stands in contrast to the other BB credits in the region like Costa Rica and Guatemala. There is also a clear differentiation on technicals. The Dominican Republic should offer a liquidity penalty as a frequent issuer against the infrequent issuance from Costa Rica and a much smaller stock of bonds. This should require a liquidity penalty and a wider spread (maybe 20 bp on the longer end of the curve). The 2.5- to 3-point selloff on the longer bonds only unwinds the spread discount, with the Dominican Republic now flat to Costa Rica but without compensating for the liquidity penalty.
The relative valuations for the Dominican Republic still look some stretched at a 20 bp spread to ‘Ba1/BB/BB’ higher rated and “illiquid” Brazil and trading at a deep 60 p to 110 bp spread discount to Panama and Colombia. The technicals are quite relevant at a mature phase of a risk-on rally and seasonal phase of Eurobond issuance from October through January. The permanent withdrawal of tax reform implies even wider relative valuations without a one notch upgrade to BB and a harder trajectory towards fiscal consolidation. The bottom line is that the social and political pressures are quite relevant and require a track record for fiscal consolidation under the ambitious assumptions of the fiscal rule.
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